By Guest Blogger Doug Rowat
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It’s hard to write a financial blog and not occasionally quote Warren Buffett. I often resist because his quotes are used so frequently that they’ve become cliché. I’m sure baseball announcers struggle the same way trying to avoid quoting Yogi Berra.
But damn. Buffett’s quotes are sometimes just plain perfect. So, as the coronavirus wreaks havoc on financial markets and as I survey the pummeled ETF landscape, I’m reminded of Buffett’s old line, “only when the tide goes out do you discover who’s been swimming naked.”
And the coronavirus has revealed a lot of naked ETF swimmers. Mainly of the leveraged variety.
I’ve warned investors before that 1) ETFs frequently, and often unexpectedly, close up shop and 2) leveraged ETFs, while performing as designed, can still overwhelm investors with their incredibly poor performances.
The events of 2020 have shown that these warnings were prescient. The Wall Street Journal recently cautioned that 2020 will likely see a record number of ETF closures (and its data doesn’t even include all of March) and, not surprisingly, ETF.com reports that a disproportionate number of these closings have come from the leveraged and inverse ETF space. In fact, ETF.com called what we’ve seen in this category over just the past few weeks a “bloodbath” as almost 30 leveraged products have been shut down, eight of them from Direxion alone. Rival ProShares has shuttered six.
An ETF closure is, of course, undesirable—funds must be redeployed elsewhere creating reinvestment risk and there may also be unexpected tax consequences—but this only amounts to a salting of the wound if the closure itself follows a stunningly rapid drop in value, which is what often occurs with leveraged ETFs.
It’s not that leveraged ETFs are performing in ways that are different from what’s fully disclosed in their prospectuses and, in fact, leveraged ETFs have been doing a much better job of stating their risks more transparently. Direxion, for example, highlights upfront in its fund descriptions that its products are “different and much riskier than most ETFs”.
However, the real problem with leveraged ETFs occurs when investors using them only see downside risk as an abstraction and become overconfident in their outlook. It takes a real market crisis, such as the one we’re currently experiencing, for the dangers of leveraged ETFs to really sink in.
First, let’s review leveraged ETFs and outline why they can be so problematic. I provided a few of the key risks in my previous blog post cited above:
So how do leveraged ETFs work? Essentially, they use mechanisms such as swaps, futures contracts and derivatives to provide investors with 200% [or] 300%…of the daily performance (either up or down) of an underlying index. The key term, however, is DAILY returns. These are products that don’t necessarily amplify returns over the long haul, rather just the returns over one trading day. Suddenly, the concept of ‘volatility drag’ enters the picture. …If [a] see-saw pattern [of market returns] continues, your [ETF value] will continue to diminish at a dramatically accelerated rate. The results can be devastating in a very short period…
Then, of course, there’s also the possibility that your market-direction forecast itself is entirely incorrect. If you’ve picked a leveraged ETF geared to favour an uptrending market and the market goes straight down, you can rack up even more significant losses also incredibly rapidly. In the past 10 years, the S&P 500, for example, has actually recorded a weekly decline of 3% or more 47 times, so it’s not as if meaningful short-term downturns are black swans—they occur constantly. And during the credit crisis there was even a week where the US market dropped more than 18%. Imagine how you’d fare with a…leveraged ETF during any of these stretches…
Well, proof that I was right about bad weeks occurring constantly for the S&P 500 has been provided by the coronavirus crisis. But let’s focus on my second point: getting your market-direction forecast wrong. If you’d felt a year ago, for instance, that things were as bad as they could get for the oil & gas sector and were certain that it was poised for an upswing, you may have made an investment in the Direxion Daily S&P Oil & Gas Explorers & Producers 3x Bull ETF (GUSH). Well, thanks to volatility drag and your incorrect forecast, you would have, quite literally, lost ALL of your money after only 12 months:
Direxion Daily S&P Oil & Gas Explorers & Producers 3x Bull ETF (GUSH) – one year
Source: Bloomberg
And, along the way, you would have been forced to become very comfortable with gut-wrenching 20% down-days. They occurred constantly. There was even one day recently where GUSH dropped by more than 80%. Again, that’s 80% in a SINGLE day.
Direxion Daily S&P Oil & Gas Explorers & Producers 3x Bull ETF (GUSH) – sample daily returns
Source: Bloomberg
In addition to closing eight of its ETFs, Direxion also announced that it was reducing the leverage on another 10 ETFs from 3x to 2x, including GUSH. So, your investment that gave you 3x leverage on the way down is now only going to give you 2x leverage on the way up. Further, though GUSH hasn’t officially closed yet, with a 75% decline in its market cap since the highs of last year, this remains a distinct possibility. Then your losses will become permanent.
Many overconfident investors think that they’re prepared for the risk and volatility that comes with using leveraged ETFs, but in reality they’re not. And many don’t fully understand the shockingly sudden consequences of an incorrect market forecast.
Or as Yogi might put it, leveraged ETFs teach you very quickly that if you don’t know where you’re going, you’ll end up someplace else.
Doug Rowat, FCSI® is Portfolio Manager with Turner Investments and Senior Vice President, Private Client Group, Raymond James Ltd.